Friday, July 27, 2012

The Search For Yield

As I wrote yesterday, the one consistent theme in my recent client meetings is the frustration with today's record low interest rates.

Bond rates are low for a reason - investors are scared to death of events in Europe.  Recent economic data indicating a slowdown in economic growth does not exactly confidence either, nor does the poisonous political environment.

Writing in this morning's New York Times, Paul Krugman points out that many investors have been consistently surprised by the continued march of lower interest rates:

For years, allegedly serious people have been issuing dire warnings about the consequences of large budget deficits — deficits that are overwhelmingly the result of our ongoing economic crisis. In May 2009, Niall Ferguson of Harvard declared that the “tidal wave of debt issuance” would cause U.S. interest rates to soar. In March 2011, Erskine Bowles, the co-chairman of President Obama’s ill-fated deficit commission, warned that unless action was taken on the deficit soon, “the markets will devastate us,” probably within two years. And so on. 

After noting that the U.S. government can now borrow money more cheaply than any other time in our history, Dr. Krugman explains why so many economists got the direction of interest rates wrong:

So what is going on? The main answer is that this is what happens when you have a “deleveraging shock,” in which everyone is trying to pay down debt at the same time. Household borrowing has plunged; businesses are sitting on cash because there’s no reason to expand capacity when the sales aren’t there; and the result is that investors are all dressed up with nowhere to go, or rather no place to put their money. So they’re buying government debt, even at very low returns, for lack of alternatives. Moreover, by making money available so cheaply, they are in effect begging governments to issue more debt.

Low interest rates are causing investor to look for yield anywhere they can.

The Telecom sector of the S&P 500, for example, is the best performing sector of the S&P 500 year (+13.5%) largely because it sports an average dividend yield of 4.8%.

The problem is exacerbated for large investment pools such as pension plans and endowment accounts.  Typically a significant portion of their assets are allocated to fixed income, but with yields so low the bond portion of their accounts are not able to meet their return objectives.

The Financial Times noted earlier this week that low rates are forcing investment committees to look for more risky alternatives to try to meet their investment objectives.  However, the results so far have often not proven to be a panacea either:

Andre Perold, chief investment officer for High-Vista Strategies, a hedge fund, and former professor of banking and finance at Harvard, says that in this environment the only way to hit return targets is through greater risk-taking - for example, through higher allocations to equities and equity-like assets.

But for most institutions, he says that such an approach is a "loser's game".  Calpers {Calfornia Public Employees' Retirement System, the nation's largest public pension plan} is a case in point.  The pension fund has $5.1bn invested in hedge funds, but the five-year annual return from its Absolute Return Strategy is 0.7 per cent - better than its overall portfolio but far worse than that claimed for the average hedge fund and nowhere near its long-term return requirement.

I continue to recommend to clients that dividend-paying stocks not only make investment sense, but are also probably the only way they will be able to meet their own personal financial targets.

But I also point out that it will not be a smooth ride.